Today, despite tax-free bond yields that are at their lowest since the 1960s, municipal bonds continue to provide the highest after-tax yields relative to other fixed-income investments.
With this yield advantage in mind, muni investors frequently ask how to uncover the best values in this new market environment.
Although contrary to the instincts of most individual investors, the best returns are found in bonds trading above 100.00 (aka premium bonds).
What is a premium bond?
Premium bonds don’t start as such. It is likely that they were originally issued at par (100.00). Since they were issued when interest rates were higher, the bonds pay more interest than those being issued today.
It’s simple arithmetic
If you have been investing in bonds over the last five to 10 years, you own bonds in your portfolio that command a premium price today, even though you may have purchased them at par or at a discount. If you were to sell these bonds, they would be priced to approximate the current interest rate environment. Obviously, an older 5.50% bond will sell at a higher price than a 3.50% bond issued today at 100.00. Thus a premium bond is born.
Higher yield
Premium bonds invariably provide a greater yield to maturity and to their call date, than par or discount bonds of the same quality. Their higher coupon rates also generate greater cash flow for reinvestment.
U.S. Treasury and corporate bonds also trade at a premium, but it is only in the municipal bond market that premium bonds yield substantially more to maturity than par or discount bonds. This is because the tax-free market is dominated by individual investors rather than institutions. Individual investors frequently avoid bonds selling above 100.00, thinking that paying a premium represents some sort of penalty. They often overlook the benefit of increased cash flow, incorrectly fearing the premium dollars are “lost,” as opposed to recognizing that these additional dollars are all working at the stated yields.
Think yield
Sophisticated bond investors are not distracted by the dollar price of a bond because they focus on yield. They know that since many individuals avoid premium bonds, it results in less demand for bonds with larger coupons. As with any other product or commodity, this softer demand lowers prices and subsequently causes the yield to maturity on these bonds to be as much as 50 basis points higher than the yield on new issue par bonds. Conversely, because most individuals are more comfortable with par bonds, the demand for those securities causes them to become overpriced.
Be careful: The larger coupons on premium bonds make them more susceptible to being called prior to maturity. It’s important to know when your bonds can be called. Your purchase price must reflect the “worst case” yield on your bonds, in the event they are called.
Rule of thumb
Finding the hidden value in premium bonds is easy if you use this simple rule of thumb: Make sure the yield-to-call is higher than the yield available on a par bond maturing in the same year.
For example, in today’s new-issue market, a bond due in 10 years would yield approximately 3.00%. So if you are buying a premium bond that is callable in 2022, the yield-to-call should be 3.25% to 3.50%. The yield-to-maturity should also be higher than the yield available on new issues maturing in that same year. In other words, the right premium bond will have a yield-to-maturity significantly higher than the 3.75% available on bonds selling at 100.00 today.
Win-win
If you follow this guideline, you are in a win-win situation: If your bond is called, you receive a higher return than if you bought a bond maturing in that year. If the bond is not called, your yield to maturity will be higher than comparable par bonds issued at the time of your purchase. You come out ahead either way.
Purchasing a premium bond with a yield advantage to the call as well as to maturity will always provide the best value.
Remember, if you are buying shares of stock, think “dollars.” When investing in tax-free bonds, think “yield.”